Working Paper: NBER ID: w9571
Authors: Mila Getmansky; Andrew W. Lo; Igor Makarov
Abstract: The returns to hedge funds and other alternative investments are often highly serially correlated in sharp contrast to the returns of more traditional investment vehicles such as long-only equity portfolios and mutual funds. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure, i.e., investments in securities that are not actively traded and for which market prices are not always readily available. For portfolios of illiquid securities, reported returns will tend to be smoother than true economic returns, which will understate volatility and increase risk-adjusted performance measures such as the Sharpe ratio. We propose an econometric model of illiquidity exposure and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.
Keywords: No keywords provided
JEL Codes: E0; E5; E6; F0; F3; G1; G2; O2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| illiquidity exposure (G33) | serial correlation in hedge fund returns (C22) |
| smoothing of returns (G17) | downward bias in estimated return variance (C51) |
| smoothing of returns (G17) | positive serial return correlation (C29) |
| illiquidity (G33) | smoothing of returns (G17) |
| smoothing of returns (G17) | understatement of volatility (G17) |
| understatement of volatility (G17) | inflation of risk-adjusted performance measures (E31) |
| induced serial correlation (C22) | impact on Sharpe ratio (G40) |
| highest serial correlation (C29) | more illiquid funds (G23) |
| smoothing correction (C20) | less attractive performance characteristics (L15) |